Market Insights

Thus far, the market’s reaction to North Korea’s missile launches has been predicated on the (allegedly) rational view that it’s sabre rattling and neither side will really let this turn into anything significantly awful. That leads to the logical conclusion that it provides a great opportunity to buy the dip in risky assets; or if you want to get cute, in Defense ETFs. After all, the cheap money party keeps on rolling, what with the Fed’s hiking almost entirely neutralised by equities rallying and credit spreads narrowing. Here’s a nice St Louis Fed chart of how mortgage rates have come down at least 25bps since the start of the year:

Same story in the Eurozone, even with the currency at two-year highs. Here’s Citi’s Financial Conditions Index – printed alongside GDP just in case we were in any doubt that growth is always and everywhere a monetary phenomenon (!):

So why should some posturing between two men with remarkably unusual haircuts give us any cause for concern?

Firstly, those haircuts are sitting atop some potentially irrational brains.

The Cold War’s M.A.D. doctrine taught us that annihilating one another was, as the name suggests, mad. Even a computer called Joshua knew that. But what if the men with their fingers on the nuclear button were less than fully rational; or if there were a miscalculation? If instead of playing noughts and crosses they thought they were playing battleships? After all, Trump, in relentlessly optimistic mood, just described the relief efforts after Hurricane Harvey as “a wonderful thing… I think even for the country to watch and for the world to watch”. He is not the Reality TV President for nothing. Always setting the scene and talking up the ratings. Meanwhile the North Korean leader has been described as “a little unhinged” by no less than former Sec of State, Condoleezza Rice. She has also been adamant that if North Korea even look like they’re getting close to being able to launch an ICBM, they must be blown off the face of the planet. And that’s from a woman with decades of experience in national security, including non-proliferation talks in the 2000s with the North Koreans themselves.

The theory then goes that the US clearly know what they’re doing behind the scenes, the North Koreans can easily be crushed, and no need to worry as we go back to buying those cheaply-funded risky assets. If you’re worried, maybe buy a safe haven for portfolio protection. But please do not under any circumstances miss out on buying the dip. As we have previously discussed, ‘We Are All Passive Now’ and the wall of money into index products is just multiplying the effect from the cheap money party. As CDOs once provided the vehicle to leverage up debt upon debt, now ETFs provide the vehicle to leverage up liquidity upon liquidity. Central banks made the price of money negative, so use that liquidity to buy more something even more liquid.

Unfortunately this propagates the mispricing of risk through the system. Where once the VIX was an indicator of risk, it’s now an asset in itself. So if North Korea accidentally sets off nuclear war, and the VIX spikes, that’s just another opportunity to sell it. It no longer represents “a forward looking indicator on volatility”, but instead just another number that mean reverts. And the mean of the past few years, ever since central banks popped up to smooth down volatility, is that nothing much happens. OK, there were little weird one off flash crashes and stuff like Brexit, but that was just over in a heartbeat, right?

There is talk of sanctions being put into place for N Korea. This is a country that ranks at 213 out of 230 on GDP per capita, just below Haiti. The population is already starving and beaten into submission. The wealth of the few is already likely to be stored below the radar. Sanctions might look like a nice next step before the pre-ordained military response kicks in. But we will hear the word “sanctions”, and decide again that we are reverting to the mean, everything is fine, nothing to see here, please move along.

We like to think we are smart. That we learn. That we wouldn’t repeat the mistakes of the past. That setting off nukes is so insane as to be impossible, rather than just highly improbable. That we wouldn’t rely so heavily on mathematical models to become trapped in a “six sigma” event. That we wouldn’t use a volatility indicator like, say, the VIX, to model future expectations of volatility.

Let’s just take a look a little more closely at what constitutes that financial conditions index we saw above:

The light blue bars are the period of the Great Moderation. Unsurprisingly they’re almost all moving in the direction of loosening. But now look at the dark blue bars, which represent the first half of this year. Some of the classic credit indicators, like 3month Euribor-EONIA (at the bottom), have reduced far more this year than they ever did in the big credit boom. The impact of the rally in the Eurostoxx has also had a bigger loosening effect. Corporate spreads have narrowed similarly. Quantitative Easing is the culprit.

Let’s leave aside whether that’s good or bad – hey at least the bar representing a mad house price boom isn’t quite as large this year, so another credit crunch looks unlikely. And instead turn back to North Korea. We can conclude:

Market-based measures of volatility are no longer providing a signal for future volatility

Market-based measures of credit risk are no longer providing a signal for future volatility

Summer is drawing to a close, and the scent of blossoming flowers and sweet seaside air is being replaced by slightly less sweet City aromas and a desire to own cardigans. To be blunt, porridge is back on the agenda. This back-to-school feeling usually means taking a fresh look at the market and hunkering down into Q4. Unfortunately, determining the driver for the months ahead is complicated. We started look at the ongoing tussle between three candidates before the summer began, and we are still no closer to one emerging as the victor. Is it carry? the economy? or politics?

1, Carry

The free money game is up! The ECB were supposed to be lining up their taper by now, courtesy of a dramatic flourish from interloper Mario Draghi at the annual Jackson Hole central bank symposium. Oh, but what’s this we see from Reuters yesterday? “ECB sources” are having a little chat are they?

‘Rapid gains by the euro against the dollar are worrying a growing number of policymakers at the ECB, raising the chance its asset purchases will be phased out only slowly, three sources familiar with discussions told Reuters…. “The exchange rate has become a bigger issue,” one of the sources told Reuters. “It is now less favorable for an exit and a stronger argument for a muddle-through option.”’

“The appreciation of the euro to date could be seen in part as reflecting changes in relative fundamentals in the euro area vis-a-vis the rest of the world” but “concerns were expressed about the risk of the exchange rate overshooting in the future”

It turns out that they’re not in quite such a rush to take back their easing after all, what with the almost 10% rally in the Euro against the USD since June. And, we might add, what with the German election becoming a snooze fest. The start of the year had seen some explosive headlines in the German press about how the ECB needed to remove stimulus ASAP, partly given the pain inflicted by negative interest rates onto savers, but also partly because inflation had returned with a vengeance to 2%. Until the most recent print, however, inflation had ebbed away, removing an argument for the ECB’s hawkish critics to use against it:

2. The Economy

So the ECB no longer need to be in a rush to cut back on their extraordinary stimulus. [Aside from that whole “running out of bonds to buy” / “distorting the usual norms of finance” type stuff, of course.] The general trend lower in inflation is happening globally, and is keeping the Fed from getting too carried away themselves with their exciting shiny new rate-hiking cycle. Janet Yellen herself may only have 4 FOMC meetings left (of which only two are accompanied by a press conference and the summary of economic projections) – meaning just two chances to decide where she would like the top of this ‘cycle’ to be. It’s as if the whole Fed is hoping just to see out those meetings without too much drama. After all, her replacement could be someone entirely unexpected, what with the rate that DJT is churning through his appointees (#IvankaForFedChair). While they wait, equities rally, spreads tighten, and financial conditions become easier. While the ECB wait, the Euro rallies as domestic Euro-area investors stop their mad dash out of European bonds into higher-yielding assets. No need for that if the ECB are about to start tightening, and when foreign bonds no longer offer such a juicy extra pick-up in yield. The summer speech from the ECB’s Coeure had some great charts on this flow dynamic:

This is now starting to reverse. Money doesn’t sleep, as Gordon Gekko v2.0 warned us, and while the central banks believe economic conditions can leave them on the sidelines, the players are still on the pitch running around.

3. Politics

Those self-same central bankers deliberately mandated the death of volatility, didn’t they? By making the risk-free rate negative, they darn well told us to go out there and buy-buy-buy anything risky. So, as those players on the pitch buy Euros and sell USDs, they’re also happily snaffling up any spike in volatility. Selling volatility has become the winning strategy. So much so, that the NYT profiled a guy they describe as a former manager in a Target Store, for ditching the day job to trade the VIX, and make 12 million dollars in the process. In the two weeks after that article came out, the two ETFs that make money from going short the VIX both took in $1.2bn of assets:

This was reported just after North Korea sent a missile over Japan. The juxtaposition of these events caused much head scratching (or hilarity from the more unkind section of finance followers). Guys, we could be facing nuclear war here, and you’re sitting at home clicking “add to basket” for a leveraged sell-vol ETF? Hey and just ahead of the ECB taking back its stimulus programme? And hey what about this whole Brexit negotiations already potentially collapsing on round 3 of the talks? Liam Fox, Trade Minister, this morning is warning the EU not to blackmail the UK over the divorce bill. He hasn’t had his porridge.

So we’ve got less divergent monetary policy, meaning less carry to be earnt…
We’ve got somnolent economies, growing but without much inflation…
Investors selling volatility and picking up yield where they can…
And politics sending us onto the edge of nuclear war / US impotence / UK breakdown.

We may be hitting peak holiday / max exhaustion for investors, but while everyone is asleep on the beach, the sun is not beating down upon them benignly. Oh no, the sands are shifting. We now know:

Trump reality is setting in

He’s a man who has always divided and conquered, when it comes to his cadre of employees. The only people he truly trusts are his family. He will continue to recycle through people until he will end up with just a few trusted lieutenants in key positions. Ivanka for Fed Chair? Don’t rule it out.

That’s only a half joke, and is a reminder that Yellen’s time is running out – hence planning further moves from the Fed here is tricky.

The Fed are on hold, for now

The Fed Minutes this week showed a clear division between those who continue to be worried about anemic inflation, and those who sense that financial stability is at risk from loose conditions. Even with the hikes that have taken place, the ongoing stock market rally / tighter credit spreads mean tightening has been neutralised. Cheap money is still with us.

The ECB are not doing anything fast

It looked as if they were gearing up to signal their taper. But with Merkel looking comfortable into the German election, maybe the ECB don’t need to be as aggressive on their return to “normal” policy as they had first thought. Not least because the sniff of a move in that direction took the Euro up to the year’s highs. As the ECB minutes revealed this week, this has rattled them:

“The appreciation of the euro to date could be seen in part as reflecting changes in relative fundamentals in the euro area vis-a-vis the rest of the world” but “concerns were expressed about the risk of the exchange rate overshooting in the future”

Again, cheap money stays with us.

Brexit reality is setting in

The UK government is putting forth position papers. Not unsurprisingly, the EU isn’t agreeing to it all immediately. The fact is that we will run on and on with this until the clock ticks down to midnight and the UK’s hand is forced. Of course, if Theresa May hadn’t decapitated herself with an unnecessary election and thus rendered any negotiation strategy impotent, this could have been different. But this is now the course we are on, and money will start to ebb away from the UK as the arguments roll on.

So, what can we conclude?

the UK and the US are looking politically unattractive investment destinations.

The G4 central banks arbe backing away from having to do anything much. Interest rates are therefore less of a driver

Volatility can remain suppressed by the continued cheap money party. But finding good carry at good valuations is becoming increasingly difficult. So volatility remains prey to the unexpected. Which takes us back to the political risk dimension.

Check out this chart of the USD vs DJT’s approval ratings:

We have previously discussed that the last few months have been a tussle between the economy, carry and politics as the driver. With the first two now subdued, the latter can step into the spotlight.

Just as the lights go out.

Enjoy the total eclipse on Monday. Weirder things have prompted market corrections.

Everyone, and I mean everyone, is on holiday. Twitter users either post photos of empty tube carriages, or worry Brexit/Nuclear War might kill everyone, and if they don’t, they might just kill themselves because of the stupidity out there. In short, there’s tumbleweed blowing through our wild west town, with just a few old drunks shooting the proverbial amongst themselves. And what are those drunks with a focus on the market mumbling about? Well if there are all these things out there to kill us, why are investors so complacent? Tighter and tighter ranges on the S&P, and volatility measures falling lower and lower… A smart shooter at the OK Macro Corral even begged Blondemoney not to write yet another article about volatility. Not least because, as flagged in “We’re All Passive Now” note of a couple of weeks ago (hit reply if you didn’t receive it), the central banks have clearly mandated a low risk / high return market. The surprise is that we are so surprised. If the risk free rate is negative, then it makes sense to fill up your boots with the riskiest things out there. As we said on 28th July:

Staving off the depression risk has now mandated an almost deliberate and inescapable euphoria.

But we all know this Truman Show world can’t last forever. Well, not in a world in which other clear and present risks are being ignored. Like, say, political risk. The threat of Nuclear War. That sort of thing. This chart puts it perfectly (from @charliebilello):

War, it turns out Edwin, is actually good for something – yes the ETF for Aerospace and Defense stocks. Let’s just take a step back for a second there. What we are saying is that not only can the threat of nuclear war be hedged by buying this ETF, it could actually be profited from. Woohoo, they never taught you that in prepper academy huh? Just before you close the door on the bunker, make sure you buy that ETF hey?

A risk is just another return stream. Because the central banks made risk equal zero (or less than zero in some cases). Hence “Buy the Dip” has been the big winning strategy of the past 18 months. This created a virtuous circle in which it was just a question of rotating around between these ETFs as you rolled into higher and higher returns for relatively cheap cost. After all, the ETFs are always super liquid, right?

So far, so good. [Apart from that whole “being unable to price the VIX for the first 30 minutes of trading” thing that happened on August 24th two years ago.] But yes, forgetting that, because that was ages ago and passive assets under management have exploded even further since then… what could cause an accident to happen again?

It’s not simply a question of inevitability. The force of the passive wall of money is strong. QE was strong too. As was the “savings glut” of the 2000s Great Moderation. Persistent buyers can make the world look irrational longer than you can remain solvent. So what could stop them?

A change in the risk-free rate. Well, tapering is a-coming from negative rates fans, the ECB. The BOJ have already slowed down. Into the end of the year, this is shifting.

A change in the economic outlook. Recession, or rampant inflation (or heaven forfend, both!) would shift the dial on expected future growth.

A change in the market structure.

This last one is the simple one, really. Let’s get back to first principles of a market. Prices of oranges and apples move around on supply and demand (which may be determined by the outlook for the economy, but let’s not use economics if we don’t have to, it really is tiresome). What if one day, the whole village goes on holiday. Suddenly, no prices are traded. They may be published, but no one is interested. The stall holders start messing around with prices to see if they can attract anyone along. You start getting bigger jumps in prices. The same could happen if either none of the sellers turned up; or none of the buyers. Prices would spike or fall to try to find an equilibrium. Nothing really changed fundamentally – it’s just that oranges keep going up 2% in price every day and one day, the buyers don’t bother to buy. No rhyme or reason. Sure, it might end up being about “value” – at some point it just hits a price that everyone thinks is way too much for an orange to sell for. But really it’s just that you can’t find one extra marginal buyer.

And so even in the wall of passive money, there may come moments where there is just very little volume trading. In the heart of the summer, say. And then the market’s bias becomes clear. If it relies on sellers every day (for example selling volatility), and it just runs out of sellers at that price… then the price jumps up. And so, out of nowhere, we get a day like yesterday: the 8th largest 1-day % increase in the history of the VIX…

Of course, you can argue that percentage increases are going to look big when you’re starting off with much lower numbers. It’s notable that in the top 10 there, 5 of them occurred in the last 2 years. But that doesn’t really matter if you were short it – you’ll still feel the pain whether starting at 11 or 32. If anything, it means that these kinds of bigger accidents are more likely to happen.

Just like the market for oranges. If, instead of having a mixture of buyers and sellers every hour and every day, you just have constant buying, day-in, day-out, day-after-day, then you will get big moves if everyone doesn’t turn up to the market one day.

For now, then, this is a summer holiday wobble that is likely to see higher vol of vol for a few days. The snapback could be sharp indeed, with these kinds of prices attracting people back to the market from the beach. If they were happy selling at 12, 11, 10, 9, 8.84, then 16 is an absolute steal, isn’t it folks? Hmm but what about nuclear war over the weekend… yeah but remember the ETF above??

And so the wall of money continues. But the cracks are starting to show. Political risk remains the likeliest sledgehammer to crack the passive party eventually. But we can have some illiquidity induced wobbles before then too.

On Monday night the reality soap opera that is the White Horse delivered an almost unimaginable plot twist. The excitingly-named and expletively-driven Anthony Scaramucci was ignominiously deposed as Communications Chief only 10 days after the President announced his appointment. Indeed, in the Alice in Wonderland world in which we live, he actually left the job 15 days before he officially started. Court jester commentators thus had a field day, comparing White House turnover to an episode of Game of Thrones. Blondemoney’s father even departed promptly from the pub in order to catch the news. Truly it is must-see viewing for everyone when the office of the most powerful man in the world indulges in gossip-strewn self-immolation.

Before anyone gets on their high horse about degradation of the office, perhaps there should be a sidebar discussion on matters such as Monica Lewinsky’s dress or the Watergate tapes. That doesn’t concern us, however. What should concern us is that risky assets rallied hard, and particularly US assets, after the Republican clean sweep in November’s elections. Some of it because of an already burgeoning global reflationary force; some of it because the Republicans were expected to rip up, revolutionise and reform the tax system.

Eight months on and what do we have? Intractable and endless pained attempts to repeal Obamacare, let alone agreement on what to replace it with. Distractions about collusion with Russia. Sabre rattling over North Korea. Executive orders that inflame but don’t solve. Certainly nothing concrete that could boost the economy. Which is what the markets are supposed to discount, is it not?

Some argue that a navel-gazing government can be good for the economy. With politicians distracted by their own in-fighting, they meddle less, leaving an economy to find its own equilibrium. The excellent Janan Ganesh in the FT yesterday urges us to ‘enjoy the caress of weak government‘.

Theresa May has been hamstrung from doing anything too disastrous on Brexit, he argues, as a kind of quasi Cabinet government has broken out; ‘a precarious administration can fumble its way to more sensible outcomes than a leader who has what the French president Emmanuel Macron calls “Jupiterian” power.’

Perhaps this is why the White House’s regular reality TV “You’re Fired!” slot is greeted with barely a shrug by financial markets. Who cares about the President reordering the pawns on the chessboard, if it keeps him out of trouble?

There is one big reason: Power abhors a vacuum.

A team without a leader will eventually seek a new leader. The team disintegrates. The centrifugal force imposed by a leader harnesses the team. Without it, it will become unstable. It’s a bold step to consider the UK’s current governing powers as “cabinet government”, rather than just ‘a succession of Cabinet Ministers outlining mutually exclusive ideas about Brexit’ (as one of m’learned political friends puts it). With no discipline from the top, each minister is incentivised to go for the jugular and capture the power. Hence endless rounds of briefing and counter-briefing from the ever-more ideologically-bereft Dodo-ministers of Hammond, Johnson, Fox and Davis. We haven’t even seen this get into full swing yet. At some stage the realisation that the clock is ticking down on the UK’s inability to negotiate Brexit will hit the market hard. As will the understanding that the risk of a new government is not zero. In a minority government, the key is to carry the confidence of the public with you. So, as public mood ebbs and wails, things that seem unimaginable now can easily happen later. Tory dissenters, egged on by a pitchfork anti-hard-Brexit mob, join Corbyn to call a vote of no confidence and then form a new government within the 14 days required by the Fixed Term Parliament Act so as to avoid an election? Don’t count it out.

Meanwhile Trump is not mucking about with the chess pieces just to amuse himself between rounds of golf. He’s constantly testing the levers of power. Trying to bully and then coerce healthcare reform didn’t work. Travel bans didn’t work. At some point he’s going to stumble on the one that does. And that one is foreign policy.

That came out of nowhere. For all the sniggering about Russia, or gossiping about his kids, this man still does have power. Indeed the greatest curb on a President’s power is the burden of expectation. Note that pretzel-choking George W Bush enacted massive tax cuts and war in Iraq, while Nobel Peace Prize-winning Obama’s healthcare reform may not survive. To borrow a Bush-ism, misunderestimating The Donald would not be wise. He’s already half way through a war of words with China over North Korea. Even the well-respected former Secretary of State Condoleezza Rice doesn’t believe N Korea can ever even get close to the possibility of having nuclear missiles. She has said that the US would have no choice but to stop them.

Let’s put this imminent threat of war, and collapsing governments, to one side. If I told you the last 9 days in the S&P has seen the lowest realised volatility in two decades, you probably wouldn’t care. Or be surprised. You might go out and sell some more volatility. It’s the summer. Central Bank aggregated balance sheets are still growing. Passive money is still buying any dips. So who cares? Putting this political nonsense to one side is the de facto stock position for stock investors.

It’s just reality TV soap opera nonsense, right?

Except the central banks are pulling back….
The passive money may eventually pull back….
If the politics becomes less of a game and more of a reality.